Ch 1 & 9

The Role of Accounting in Business Chapter 1 and Chapter 9 (pp. 268-272 only) A200 - Survey of Accounting University of Tennessee Spring 2009 Objectives Chapter 1: Describe the types and forms of businesses, how businesses make money, and business stakeholders. 2. Describe the three business activities: financing, investing, and operating. 3. Define accounting and explain its role in business. 4. Describe and illustrate the basic financial statements and how they interrelate. 5. Describe eight basic accounting concepts underlying financial reporting. Chapter 9: 1. Describe basic financial statement analytical procedures. Obj. 1: Types of Business Manufacturer: Buys basic inputs (Materials, Labor, and Overhead) from suppliers. Converts them into a finished product (?goods?) for sale to merchandisers. Merchandiser: Also called ?middlemen?. Buys finished goods from manufacturers and sells them to customers. Service: Does not sell goods. Provides services to customers (human knowledge, talent, or strength). Obj. 1: Forms of Businesses Proprietorship: Owned by one individual; Not a separate legal entity from owner. Advantages: Easy and inexpensive to organize. Disadvantages: Financial resources are limited to what the owner has or can individually raise. Owner is 100% liable for all business debt. Business income is taxed 100% to the owner. Proprietorship terminates when owner dies. Partnership: Owned by two or more individuals or other entities. Advantages: Easy and can be inexpensive to organize. Generally, more financial resources are available to partnerships than to proprietorships. Disadvantages: Each partner is legally liable for the actions of other partners. Partnership income is taxed to the partners. Partnership terminates when partner dies. Obj. 1: Forms of Businesses Corporation: Legal entity separate from its owners (stockholders.) Advantages: Can generate large amounts of capital through sale of stock (ownership shares.) Stockholders are at risk for only the amount they invested (limited liability.) Corporation continues even if stockholders die. Disadvantages: Stockholders may not have the control they desire over the affairs of the corporation. Limited Liability Company (LLC): Legal entity separate from its owners (owners are called members.) Advantages: Members are at risk for only the amount they invested (limited liability.) LLCs can generally raise more financial resources than proprietorships and partnerships. Disadvantages: Business income is taxed to members. LLC terminates when members die. Obj. 1: How do businesses make money? Business Strategy: How a business gains an advantage over competitors. How the business increases revenues and/or lowers costs to maximize profit. Generally, businesses choose one of the following overall strategies: Low-cost emphasis: Design and produce products or services of acceptable quality at a cost lower than its competitors. Premium-price emphasis: Design and produce products or services that have perceived unique qualities for which a customer is willing to pay a premium price. Obj. 1: Business Stakeholders External Stakeholders Capital Market stakeholders: Provide financial resources to business. Lenders: Want the business to succeed so they can be paid back with interest. Owners/Stockholders: Want the business to succeed so they can earn a return on their investment. Product/Service Market stakeholders: Sell goods or services to the business (suppliers) or buy goods or services from the business (customers). They want the business to succeed to they can continue dealing with it. Government stakeholders: Collect taxes from the business and regulate business activities. Want the business to succeed so government revenues increase. Internal Stakeholders Business managers and employees: Want the business to succeed so they will continue to have jobs. Obj. 2: Financing Activities Financing: Acquiring cash or other assets to (1) start a business, (2) acquire more assets, and (3) operate the business. The basic Accounting equation is: Assets = Liabilities + Equity Resources owned Creditors? claims Owners? claims by the business = on the assets of + on the assets of the business the business (Debts owed by the business) This reflects the two kinds of financing: Debt Financing and Equity Financing Obj. 2: Financing Activities Debt Financing: Acquiring cash or other assets by borrowing. (more on debt financing in Chapter 8) Business increases cash or other assets and also increases liabilities, because the amount borrowed must be paid back. See slide #9 for common liabilities. Example 1: Starter Corporation began business in January 2009 by borrowing $20,000 from First National Bank. How does Starter?s accounting equation appear after this transaction? Assets = Liabilities + Equity 20,000 Cash = 20,000 Note Payable + 0 Obj. 2: Debt Financing Common Liabilities (more on liabilities in Chapter 7) Accounts Payable: Incurred when business buys supplies/goods or uses services (such as employees? labor) without paying cash. Often called ?open? accounts payable ? no formal contract, no interest. Usually short-term (due in less than one year.) Notes Payable: Incurred when business borrows money (as from a bank) or buys goods without paying cash. Formal written contract stipulating specific term and interest due. Sometimes short-term, sometimes long-term. Seller chooses whether a payable is an open account or a note. Bonds Payable: Incurred when business borrows money from investors (bondholders). Formal written contract stipulating specific term and interest due. Always long-term (due in more than one year.) Obj. 2: Financing Activities Equity Financing: Acquiring cash or other assets by either selling ownership shares (capital stock) in the business, or by operating the business, earning and then retaining its earnings (retained earnings). Increases cash or other assets and also increases equity. Example 2: Starter Corporation raises another $100,000 in January by issuing (selling) capital stock to new owners in exchange for cash. Assets = Liabilities + Equity 200,000 Cash = 0 + 200,000 Capital Stock Example 3: Starter Corporation earns $8,000 in January by operating the business (selling goods or services.) Assets = Liabilities + Equity 8,000 Cash or = 0 + 8,000 Retained Earnings Accounts Receivable increase due to Revenue earned Obj. 2: Financing Activities Dividends: When a business finances asset purchases with capital stock equity (selling ownership shares), the new owners (stockholders) want a return on their investments. One way the business gives stockholders a return is by distributing part of its earnings. This distribution is called a Dividend. Dividends can be distributed in cash or other property, or in new shares of stock (more on dividends in Chapter 8.) Example 4: Starter Corporation distributes $200 of its January earnings to the stockholders in cash. Assets = Liabilities + Equity (200) Cash = 0 + (200) Retained Earnings decrease due to dividend declared and distributed Obj. 2: Investing Activities After obtaining financing, the business makes investments in whatever resources it needs to start operating the business. The resources a business invests in are called Assets. Common Assets (more on Assets in Chapters 5-7) Tangible Intangible (physical substance) (no physical substance) Cash Patents Accounts receivable Trade names Prepaid expenses Copyrights Supplies Trademarks Land Intellectual property Equipment Goodwill Building Automobiles Obj. 2: Investing Activities Businesses acquire Assets in one of four ways: Trade another asset for the new asset. Example 5: Starter Corporation purchases equipment in January for $125,000 cash. Assets = Liabilities + Equity 125,000 Equipment (125,000) Cash = 0 + 0 Borrow. Example 6: Starter purchases a building in January for $100,000, giving a note payable. Assets = Liabilities + Equity 100,000 Building = 100,000 Note Payable + 0 3. Issue stock to new owners (stockholders). See Example 2 on slide #11. 4. Earn (sell goods or services). See Example 3 on slide #11. Obj. 2: Operating Activities After acquiring resources (assets), the business can begin operations (the day-to-day business activities that generate Revenue and Expenses.) Revenue: Amounts earned during the period from either selling products or providing services. In a transaction that increases Revenue, equity increases (via net income) and assets increase (either cash or accounts receivable). See Example 3 on slide #11 Expenses: Amounts used during the period to help generate revenue. In a transaction that increases Expense, equity decreases (via net income), and either assets decrease or liabilities increase. See Example 7 on slide #16 Obj. 2: Operating Activities Expenses: Costs incurred during the period to help earn Revenue. Cash may be paid in the same transaction, but often is not. Example 7: Starter Corporation incurs the following expenses in January: Wages expense $3,000 Rent expense 2,600 Miscellaneous expense 750 Starter did not pay cash for any of these (it will in the future). Assets = Liabilities + Equity 0 = 6,350 Accounts Payable + (6,350) Retained Earnings Obj. 3: Define Accounting and its role in Business Accounting is an information system, also called ?The language of business?. Accounting provides data to stakeholders so they can evaluate the health and future prospects of the business. Financial Accounting provides information to external stakeholders. We will study financial accounting in Chapters 1-8. Managerial Accounting provides information to internal stakeholders. We will study managerial accounting in Chapters 10-14. Purposes of an Accounting system: To report changes in the business? financial condition over a period of time. To report the business? financial condition at a single point in time (end of period). Obj. 4: Describe and illustrate the Basic Financial Statements and how they interrelate. Reporting changes in financial condition over a period of time: Income Statement: [ Revenues ? Expenses = Net Income ] (Shows results of operations over a period of time) Statement of Retained Earnings: [ Beginning RE + Net Income - Dividends = Ending RE ] (Shows increases and decreases in retained earnings over a period of time) Statement of Cash Flows: [ Beginning Cash +/- Net Cash Flows from Operating, Investing, and Financing = Ending Cash ] (Shows the cause of changes in the asset Cash over a period of time) Reporting financial condition at a single point in time (end of the period): Balance Sheet: [ Assets = Liabilities + Equity ] Obj. 4: Income Statement Starter Corporation Income Statement For the month ended January 31, 2009 Revenues: Fees Earned $8,000 (slide 11) Expenses: Wages expense $ 3,000 Rent expense 2,600 (slide 16) Miscellaneous expense 750 (6,350) Net Income: $1,650 Net Income (Revenue-Expenses) increases Equity (Retained Earnings) Revenue increases Equity (RE) and Expenses decrease Equity (RE). Obj. 4: Retained Earnings Statement Starter Corporation Statement of Retained Earnings For the month ended January 31, 2009 Retained Earnings, January 1, 2009: $ 0 (from last month?s Balance Sheet Equity section) + Net Income 1,650 (from income statement) - Dividends (200) (slide 12) (share of earnings distributed to stockholders) Retained Earnings, January 31, 2009: $1,450 (to this month?s Balance Sheet Equity section) Obj. 4: Balance Sheet Starter Corporation Balance Sheet as of January 31, 2009 Assets Liabilities Cash $102,800 Accounts Payable $ 6,350 Building 100,000 Notes Payable 120,000 Equipment 125,000 Stockholders? Equity Capital Stock 200,000 Retained Earnings 1,450 Total Liabilities & Total Assets: $ 327,800 = Stockholders Equity: $327,800 Obj. 4: Statement of Cash Flows Reports cash inflows (increases) and cash outflows (decreases) in three categories: Operating Activities: Cash received from customers (inflow) Cash paid for expenses (outflow) Investing Activities: Cash received from sales of long-term assets (inflow) Cash paid for purchases of long-term assets (outflow) Financing Activities: Cash received from the sale of capital stock or bonds (inflow) Cash paid for dividends, bond redemptions, and treasury stock (outflow) Obj. 4: Statement of Cash Flows Starter Corporation Statement of Cash Flows For the month ended January 31, 2009 Cash flows from Operating Activities: Cash inflow from customers $ 8,000 Cash outflow for expenses ( 0) Net Cash Flows from Operating Activities: $ 8,000 Cash flows from Investing Activities: Cash inflow from sale of Property, Plant & Equipment 0 Cash outflow for Property, Plant & Equipment (125,000) Net Cash Flows from Investing Activities: (125,000) Cash flows from Financing Activities: Cash inflow from issuing stock 200,000 Cash inflow from issuing notes payable 20,000 Cash outflow for dividends to stockholders (200) Net Cash Flows from Financing Activities: 219,800 Net Increase (Decrease) in Cash: 102,800 + Cash at January 1, 2009 (beginning balance) 0 = Cash at January 31, 2009 (ending balance) $102,800 Obj. 5: Describe eight basic accounting concepts underlying financial reporting Generally Accepted Accounting Principles (GAAP) rule the preparation of financial statements GAAP are written by the Financial Accounting Standards Board (FASB). GAAP are based on eight accounting concepts. Business Entity Concept: We record transactions of different entities separately. Owners are separate from their businesses, and each business is separate from all other businesses. Real-life Fraud Example: Adelphia Communications (6th largest cable provider in the U.S.) was owned by the Rigas family. In 2002, several members of the family were convicted of fraud for treating company assets as their own, to the tune of about $2.3 billion. The business concealed the Rigases? use of company funds for stock purchases, real estate procurement, and other deals. Adelphia went bankrupt and the convicted family members face up to 30 years in prison. Obj. 5: Basic Accounting Concepts Business Entity Concept Bill Stone owns and operates Stone Sports as a sole proprietorship. It sells hunting and fishing equipment and provides guided huntingand fishing trips. Bill?s wife, Sue, owns and operates Eagle Boutique, a women?s clothing store, as a sole proprietorship. Bill and Sue have one child, Joe, age 12. The Stones have established a trust fund to finance Joe?s college education. The trust fund is maintained by First Tennessee Bank in the name of their child. Question: How many different entities exist for accounting purposes? Answer: Six. Bill & Sue (married individuals are a single entity) Joe (individual entity) Stone Sports (sole proprietorship business entity) Eagle Boutique (sole proprietorship business entity) First Tennessee Bank (corporate business entity) Joe Stone Trust Fund (fiduciary entity) In A200, we will learn how to account for business entities. Obj. 5: Basic Accounting Concepts Cost Concept: We record assets at their historical cost (the amount actually incurred when the asset was acquired). Market value, asking price, replacement cost are irrelevant and are not recorded. Going Concern Concept: We assume that a business is going to continue indefinitely unless otherwise indicated. Matching Concept: We record a period?s Revenues on the periodic Income Statement with the Expenses (costs) that helped to generate those revenues. Real-life Fraud Example: World Com (2nd largest long-distance telecom operator in U.S.) inflated net income by recording $3.8 billion of expenses as assets. Result: bankruptcy and criminal conviction of CEO and CFO. Over $100 billion in stock market losses. Board of Directors fined $18 million. Obj. 5: Basic Accounting Concepts Objectivity Concept: We base entries in the accounting records and data reported on the financial statements on objective evidence. (Example: purchase invoice or receipt is objective evidence of an asset purchase.) Unit of Measure Concept: We report all financial statement numbers in dollars (in the U.S.) Accounting Period Concept: We report data on financial statements in separate time compartments. (Example: April is not the same month as May, and 2008 is not the same year as 2009.) Real-life Fraud Example: Fannie Mae (the Federal National Mortgage Association), illegally shifted expenses between periods, pushing $107 million of earnings into future years. Result: CEO and CFO fired, and the company was forced to restate earnings. Obj. 5: Basic Accounting Concepts Adequate Disclosure Concept: We report in the financial statements and related footnotes all relevant data that readers need to understand the financial condition and performance (results of operations) of a business. We leave out irrelevant data. Example: Reporting the total cash balance at the end of the year is adequate disclosure. The financial statements do not need to include the details of a $5.00 purchase of paper clips. Recall, though, that the Objectivity Concept requires that we be able to prove that $5.00 expenditure upon audit. Real-life Fraud Example: Tyco International, one of the world?s largest electronics companies, failed to disclose secret loans to executives that were subsequently forgiven by the company (never paid back by the execs.) Result: CEO and others were forced to resign and were convicted in criminal proceedings; currently serving 8-25 year sentences. Obj. 5: Basic Accounting Concepts Accounting practice is overseen by the: SEC (Securities and Exchange Commission) Has authority to set accounting principles for publicly-held corporations Delegates this function to the Financial Accounting Standards Board (FASB). Currently working to align U.S. generally accepted accounting principles (GAAP) with international financial reporting standards (IFRS) Financial Accounting Standards Board (FASB) Writes GAAP: the rules that determine the proper content and form of financial statements. Public Company Accounting Oversight Board (PCAOB) Helps regulate publicly-held companies as well as the accounting industry Created by Congress in the wake of fraud scandals of the 1990s. Financial Statement Analysis Ratios Different stakeholders have different interests in the company. Creditors (external stakeholders) are most interested in the company?s: Ability to repay its debt and to pay interest on debt (Solvency Ratios) Capital structure: How much of the company?s financing already comes from debt? (Leverage Ratios) Investors/Owners (external stakeholders) are most interested in the company?s: Ability to earn profits in the future (Profitability Ratios) Ability to give investors a return on their investment (Stockholder Return Ratios) Managers (internal stakeholders) are interested in all of the above and also in the company?s: Efficiency in using assets to generate revenue (Asset Efficiency Ratios) Current performance in relation to past performance (Horizontal Analysis) Financial statement elements in relation to totals (Vertical Analysis) Financial Statement Analysis Ratios No single ratio tells the whole story of a company?s financial condition. However, taken all together, ratio analysis can paint an accurate picture of the company?s financial condition in the current year and from year to year. Vertical Analysis: Single ratios that divide one number on a statement by the total for its category. Chapter 9, pp. 268-272. Horizontal Analysis: Comparing a single ratio to the same ratio from another period or a competitor company. (Single ratios are meaningless until we apply Horizontal Analysis.) Chapter 9, pp. 268-272. Financial Statement Analysis Ratios Vertical Analysis Ratios COGS % = Cost of Sales ÷ Sales Revenue This ratio measures how much of each dollar of revenue earned was used to buy the goods the company sold. Net Income % = Net Income ÷ Sales Revenue This ratio measures how much of each dollar of revenue is available to the Company (after all expenses) for expansion (retained earnings) or for owners (dividends).